Crimea: Why Here and Why Now?

In an effort to explain the annexation of Crimea, there has been a great deal of coverage surrounding the region’s ethnic ties with Russia and the political motivations of the move. After all, it was only 60 years ago that Crimea was gifted to Ukraine by Russia and it’s fairly understandable that Russia is a little antsy at the idea of having NATO on its doorstep in the wake of the ousting of President Viktor Yanukovych in the Ukrainian uprising. However, less attention has been paid to the underlying energy-related economic motivations of the move and therein lies a clearer picture of why Crimea is so important.

A couple weeks ago Russia’s state owned Gazprom announced that it would be tightening the screws on Ukraine by withdrawing the natural gas discount they provide in the second quarter of this year. In the wake of this, the Ukraine will likely face a price increase in the neighborhood of 30%. Ukraine enjoyed the discount on Russian gas as part of a prior agreement between Vladimir Putin and the former Ukrainian president, whereby the Ukraine rejected a pact with the E.U. in favor of closer ties with Moscow, a move that led to three months of mass protests, violence and an eventual regime change.

The Ukraine is the primary means by which Russian gas reaches Europe: 50% of Europe’s natural gas imports from Russia travel across the Ukraine. The country annually consumes approximately 50 billion cubic meters (bcm) of natural gas and produces roughly 22bcm, leaving about 28bcm to be covered by way of imports.Russia is the source for the lion’s share of those imports, at nearly 26bcm.1 As such, Moscow has enjoyed considerable influence over its neighbor since the breakup of the former Soviet Union, having gone so far as to shut off the gas to the Ukraine twice since 2006 in order to steer Ukrainian politics the way it wanted.

Russia’s annexation of Crimea was swift, unapologetic and left most the world astounded at how quickly it all transpired. There was no immediate threat and the area accounted for a meager 4% or less of Ukraine’s GDP.2  So why so fast? The answer appears to lay offshore of the Crimean coast.

The waters offshore of Crimea are said hold between 4 trillion and 13 trillion cubic meters of natural gas according to the Ukrainian government, and with development capex in the range of $8-9 billion could produce 9.7 billion cubic meters (bcm) of gas by 2030.3 However, any chance of getting out from under the thumb of Russia or realizing the future monetary value of those energy assets disappeared from Kiev’s balance sheet as soon as Crimea was annexed.  From the Kremlin’s perspective, who exported nearly 6,248bcm in 2012 according to the EIA,4 this isn’t a huge play but it’s a decent addition to their reserve base and it keeps the Ukraine in their place: a customer in need.

In the weeks before the uprising and overthrow of the government, it was reported that ExxonMobil and Royal Dutch Shell, acting as leads of a consortium, were in production sharing negotiations with the government concerning the Skifska offshore gas field. Interestingly there was only one other bid for the development of the Skifska field and that came from Moscow-based oil and gas company Lukoil.5 In the wake of the hostilities, Exxon announced that negotiations would be put on hold.6 Given that Russian legislation stipulates that any offshore production in Russian waters requires 51% of state ownership, post annexation this consortium has a new “opportunity set” to consider.  ExxonMobil and Shell may find that the new terms are not nearly as enticing as they once were. Not to worry though, Gazprom or Lukoil might be interested.

Over the years, Russia has reduced its reliance on the Ukraine as a transport corridor.  In the past 80% of Europe’s natural gas imports from Russia traveled through the Ukraine, but that has fallen to 50% following the completion of the construction of the Nord Stream gas pipeline in 2012.7  Gazprom plans to continue the process of securing its gas shipments to its largest customer and bypassing countries it doesn’t want to deal with by building the South Stream Natural Gas Pipeline. The proposed route goes under the Black Sea to Bulgaria and then on to the rest of Europe. Prior to the annexing of Crimea, the proposed route took the South Stream Pipeline around Ukrainian waters.

This is where the plot thickens. A motivating factor behind the swift annexation of Crimea may lie project costs. Estimates are that Gazprom could save $10 billion in construction costs and greatly reduce the complexity of construction by moving into shallower waters.8 In looking at the Black Sea it becomes visually apparent that running a pipeline through the Crimean peninsula (the peninsula off of Ukraine the extends well into the Black Sea) and along the shelf would be a much simpler, dramatically cheaper and easier to maintain initiative than going through the middle of the Black Sea where depths can reach more than 7,000 feet.9

Black seaCrimea blog1

(Chart: http://en.wikipedia.org/wiki/File:Black_Sea_map.png)           (Chart: http://geostrategy.org.ua/en)

In recognition of this, the E.U. is talking tough about South Stream while looking for ways to reduce its reliance on gas from Russia. As it progresses down this path it could look to countries like Iran who have significant offshore reserves. However, the fact remains, Russia has the ability to trump most foreign producers on a cost basis (no liquefaction or regasification process required and much of the infrastructure is already in place).

In summary, Russia is a resource-based economy. Oil and gas revenues account for more than 50% of the country’s federal budget revenues.10  Crimea’s annexation was to a large degree an opportunistic move for Russia that it knew it could get away with. In doing so, Moscow was able to add to its gas reserves, improve its naval position in the Black Sea and probably save some rubles as it improves its pipeline infrastructure to its number one customer.

A significant percentage of the world’s oil and gas reserves are located in regions that are becoming increasingly challenging (to say the least) to do business in. When one blends the uncertainty that energy geopolitics like this or those that can be found in resource rich regions of the Middle East, Africa or Latin America into a world that is becoming increasingly dependent on higher cost unconventional production, it becomes clear in the long run that the prices of oil and gas are seemingly destined to go higher.  We believe that finding investments in long-lived production at or below the marginal cost of a barrel of production in countries with minimal geopolitical risk is key to securing returns in the long run.

Pirani, Simon, Katja Yafimava, Howard Rogers, Anouk Honore, and James Henderson.  “What the Ukrainian crisis means for gas markets.” The Oxford Institute for Energy Studies.  March 10, 2014.
2 “Crimea a blow to Ukraine energy security and investors,” Monitor Global Outlook, March 10, 2014, http://monitorglobaloutlook.com/.
3 “Crimea a blow to Ukraine energy security and investors,” Monitor Global Outlook, March 10, 2014, http://monitorglobaloutlook.com/.
4  Source: U.S. Energy Information Administration (“Russia, Country Analysis Brief Overview” November 2013).
5 “Ukraine:  ExxonMobil Let Consortium Wins Skifska Bid,” Natural Gas Europe, April 15, 2012, www.naturalgaseurope.com.
6 Exxon Mobil Corporation 2014 Analyst Meeting, March 5, 2014.
7 Pirani, Simon, Katja Yafimava, Howard Rogers, Anouk Honore, and James Henderson.  “What the Ukrainian crisis means for gas markets.” The Oxford Institute for Energy Studies.  March 10, 2014.
8 “Crimea a blow to Ukraine energy security and investors,” Monitor Global Outlook, March 10, 2014, http://monitorglobaloutlook.com/.
9 “Black Sea,” Wikipedia,  http://en.wikipedia.org/wiki/Black_Sea.
10 Source: U.S. Energy Information Administration (“Russia,” March 2014).
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Upcoming TV Appearance

Tim Gramatovich will be a guest on CNBC’s Closing Bell with Kelly Evans and Bill Griffeth on Monday, April 21st live from the NYSE at 3pm ET.

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Peritus in the News

Tim Gramatovich of Peritus was quoted in the article, “Trillion-Dollar Firms Dominating Bonds Prompting Probes,” by Lisa Abramowicz of Bloomberg, April 14, 2014.

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Peritus in the News

Peritus’ writing “The Default Outlook” was featured on ETF Trends, April 12, 2014.

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Peritus in the News

Peritus’ writing “Avoiding Complacency” was featured on Seeking Alpha, April 5, 2014.

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The Default Outlook

On April 1st, TXU/Energy Future Holdings skipped their interest payment due that day, immediately triggering a default by some reporting mechanisms. While the company has a 30 day grace period to pay the coupon payment, most expect them to use the grace period to work further on a restructuring and ultimately file for bankruptcy at some point over the next 30 days. If the Texas Competitive Electric unit is the only entity that ends up filing for bankruptcy (and not the Energy Future unit), this will impact $8.2 billion in par amount of bonds and $19.5 billion par institutional loans, making this the largest high yield default on record and will send April default rates up for both bonds and loans.1  J.P. Morgan estimates, “Including the April 1 default of TXU, the high-yield bond and leveraged loan default rates will increase to 1.22% and 4.14% in April, respectively, up from 0.61% and 1.37% today. For context, this would bring the loan default rate to its highest level since August 2010 (4.74%).”2

There are other names that have been long-time issuers in the high yield space facing challenges, either on the brink of default, missed coupon payments, or already in the midst of reorganization.  This includes names like James River Coal (a coal company), Momentive Performance Materials (a chemicals manufacturer), and Global Geophysical Services (provider of seismic data to the energy industry).  Rather than any sort of systemic concerns for the high yield market, we see this as the weeding out of the weaker players to the benefit of the remaining, stronger companies in the respective industries.

In looking a three names mentioned above, understanding both the company specifics and the broader industry matters.  For instance in the coal space, Patriot Coal previously faced bankruptcy and now James River appears on the verge, so it seems that the marginal players will restructure and the industry rationalize, ultimately helping the rest of the players in the coal industry.  And it is also important to recognize that all “coal” is not the same.  There is thermal coal (used largely for electricity generation) and metallurgical coal (used for steelmaking) and pricing depending on the geography.  So analyzing the differences has been important and we have determined that thermal coal companies in certain geographies appear to have a much better demand profile than metallurgical coal going forward, and hence pricing.  So it appears that painting the entire coal industry the same way is unjustified in this case, yet this can allow active managers to take advantage of undervalued, stronger players in the space.  Likewise, with the seismic data space, we see strong dynamics for the industry but Global Geophysical ran into company specific liquidity issues, hence there need for a restructuring.  Furthermore in the Momentive situation, it appears to be a case of an LBO that was done in 2006 leaving the company with an elevated debt load complicated by the fact that earnings/EBITDA have fallen in recent periods.  In this case, an over-levered LBO and company specific issue, not an industry wide problem.

Barring TXU because of its massive size, we certainly don’t see any significant move up in default rates or systemic issues on the horizon.  J.P. Morgan continues to project that high yield bond default rates (excluding TXU) will stay below 2% through 2015, well under the historical average near 4%.3  So a very benign default environment will remain for the foreseeable future.  However, investors need to make sure this does not make them complacent.  Weaker players exist in a variety of industries and thorough analysis is needed to determine which are the solid companies, potentially set to benefit at the expense of others.  This is one of the dangers we see of passive, index-based investing: nothing is done to make these identifications, and we believe investors are left to face the consequences all in their effort to save a little on fees.  If you could spend the time doing the work to differentiate the marginal players versus the stronger industry participants, and make your investment decisions accordingly, wouldn’t you do it?  We certainly see this as the best approach to investing and view active management as absolutely essential in the high yield bond and bank loan markets.

1  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “High-Yield Default Monitor.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  April 1, 2014, p. 2.
2  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “High-Yield Default Monitor.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  April 1, 2014, p. 2.
3  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “High-Yield Default Monitor.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  April 1, 2014, p. 4.

 

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Avoiding Complacency

According to Lipper, $3.4 billion has gone into U.S. high yield mutual funds and exchange trade funds in Q1 2014, well above last year’s first quarter inflows of $1.76 billion.1  We have seen a very stable new issue market over the first quarter to fill this inflow of money and as companies look to refinance existing debt at lower rates.

High yield bond investing, and really investing period, not only involves picking the right security but buying it at right price/yield.  With the demand for high yield paper, we have seen the market participants get more complacent in terms of what sort of yields they require for paper.  Case and point is the Realogy deal that priced yesterday.  Realogy is the parent company of the real estate brokers Century 21, Coldwell Banker, and Sotheby’s International.  This was a company on the brink during the financial crisis, but has certainly recovered, even able to do an IPO in 2012.  Yesterday the company issued $450mm in unsecured bonds at a yield of 4.5%.  The proceeds from these bonds were being used to take out existing 7.875% bonds, so certainly an interest cost savings to the company and a benefit to existing bondholders in the company.

But as investors in the market, we look at this transaction and are left scratching our heads.  Why are investors only demanding a yield of 4.5% in a name that is certainly cyclical and is rated Caa1 by Moody’s?  Is the mentality or investment strategy of passively investing in anything that comes to market blinding people in certain cases?

We ultimately see this sort of situation as the value that active management can add to investing.  Active managers don’t have a mandate to hold any certain securities, thus they can pick and choose as to what they feel offers the best return level for a given risk profile.  As we look at this company, this is certainly the type of investment we would avoid.  The high yield bond market still offers plenty of what we view as very attractive opportunities in credits that we see as solid companies at yields about 300 basis points or more above the yield level on this bond.  To use the cliché, as investors we want to get the best bang for our buck and active investors are able to do that while also managing risk.

 

1  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li..  “High Yield Market Monitor.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  April 1, 2014, p. 10.
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Upcoming Event: Peritus on FBN

Tim Gramatovich will be a guest on Fox Business’ “After the Bell,” Tuesday, March 25, 2014 at 4pm ET.

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Upcoming Event

Tim Gramatovich will be featured on The Wall Street Shuffle radio show on Saturday, March 22, 2014 between 10 and 11 am CT.

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A Revised Timeline for a Rate Increases, Should We Be Worried?

Earlier this week we heard the results of the latest Fed meeting.  To little surprise, they continued with the “tapering” of $10 billion a month.  However, the clarity Yellen offered as to likely finishing up the latest round of quantitative easing by the fall of this year and then start looking to raise rates about 6 months after that, seemed to catch everyone momentarily off guard.  All of a sudden the market is worried that rates may be going up a few months earlier than had previously been expected.  In a knee jerk reaction, we saw Treasury yields spike and equities take a hit.  Yet on the flip side, the Fed did revise language that tied rate rising to a 6.5% maximum jobless rate, abandoning this link and giving them a bit more flexibility in waiting to increase rates, as the current jobless rate now nears that 6.5% level.

So what does this mean for us as high yield investors?  Very little.  In the scheme of things, what does it really matter if the fed funds rate starts rising in mid-2015 versus late-2015/early-2016?  Do those few months at all change our investment strategy?  No.  We are investing to generate what we see as an attractive yield for the long term, with the potential for capital gains.  Yes we do consider the interest rate environment, but at the end of the day, our focus is on yield and value.  Furthermore, as we have profiled before, high yield bonds have historically had a negative correlation to Treasury rates, and have actually performed well during periods of rising rates (see our piece “Strategies for Investing in a Rising Rate Environment”).

The other thing to consider is that markets are forward looking.  The reality is that if rates are expected to increase, the markets will react well ahead of that.  For instance, last summer when the first rumblings of the “tapering” happened, the markets swiftly reacted and Treasury rates saw a significant move in the latter half of the year.  And as we entered 2014, the consensus was certainly that rates would be rising, but so far, even with this week’s move, rates are below where we ended 2013.  For instance, the 10-year Treasury is at a yield of 2.78% (as of 3/20/14) versus ending 2013 right around 3.0%.  So have markets largely already reacted to the expectation of higher rates?  Maybe so.  This move in Treasury rates that we have seen since last summer is well ahead of any 2015 actual increase in the fed funds rate, and ultimately if that increase happens in June 2015 versus December 2015 would seem to be irrelevant.

So yes, markets are manic and hypersensitive to Fed-speak in the immediate.  But in the longer term, we don’t see the specific timing as something to be laser focused upon.  Investors instead need to analyze and determine how to broadly be positioned in this environment.  As we have recently written about, we actually see a number of factors, among them the muddling global economy, demographics, and liability driven investing, that could actually help constrain rates as we go forward (see our piece, “Of Elephants and Rates”), and so far we have seen constrained rates in the first quarter of 2014.  The reality is that we see value in the high yield market and attractive yield to be had for those that can actively pick and choose securities in that market, irrespective of whether rates rise or not.

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